Burdened by the increasing cost of fighting the Vietnam War, the US could no longer guarantee to exchange all dollar holdings for gold. Its reserves had fallen to around 20% of total dollars in circulation, down from 55% in 1946, when the US held $26 billion in gold (over 60% of global reserves).
In May 1971, West Germany, wary of inflation and unwilling to devalue the mark to prop up the dollar, pulled out of the Bretton Woods agreement. Other countries, notably France and Switzerland, exchanged more dollars for gold.
On 15 August 1971, with US gold stocks down to $10 billion or so, President Nixon ended the convertibility of dollars into gold, a move that became known as the ‘Nixon shock’. This brought an end to any semblance of a gold standard and meant the dollar became fiat money, soon to be followed by all the currencies that had been tied to it. From this period onwards, the value of most major currencies would be free to float, dependent only on the fortunes of their parent countries in relation to other nations. The price of gold quickly went up, from $35 an ounce in 1971 to $190 by the end of 1974.
As good as gold
There is no particular reason why the value of money should be linked to gold, but there is a very good reason why the quantity of money in circulation needs to be determined by something real, something related to economic activity by the real wealth of industry. Because of its rarity and long history of desirability, which guaranteed its value, gold provided a useful benchmark from which money could be valued.
Whether or not we should return to some form of gold standard is a subject that provokes even more disagreement amongst economists than most other aspects of the economy, but there’s no doubt that today’s financial problems could not have occurred if the gold standard was still in force, because there’s no way that banks could have created so much credit. The gold standard linked the value of money to genuine wealth creation, because governments had to acquire the gold (either by mining it or exporting goods that could be exchanged for gold) before they could print more of the paper stuff.
Figure 24
There is obviously a need for some form of standard that ties money creation more closely to genuine wealth creation, but it might be the case that gold is just too valuable to be used now, with money being so abundant and gold so rare. Since the end of the gold standard, the price of gold has fluctuated wildly because of speculation, but overall has shot up, as Figure 24 shows.
Gold can be traded in the same way a currency is traded, and is often bought in times of uncertainty, when currencies, especially the dominant US dollar, risk losing value through inflation. But the fact is that the value of everything, including gold, can vary relative to everything else, according to the simple free-market principle of supply and demand. The market does the valuing, which is supposedly a good thing because in theory it is the market, meaning the market traders collectively, that has the most information, and can therefore make the most accurate judgments.
But this fluidity of prices means there is no fixed value to anything, including money. And we know that markets get things wrong sometimes, that they are prone to herd instincts and can be influenced by heavy trading and deliberate attempts at price manipulation. This reliance on the market means that governments are constrained in their actions by concerns that certain economic policies will affect the value of their national currency, which in turn affects the economy.
Out of control?
Again we return to this point: that with no fixed values, the economy is governed by complicated interactions between millions of players in the global marketplace. The whole economic system has grown so large and complex that no single authority has any control or even much influence. None of it is planned; things just happen on the general basis of supply and demand, which in turn is governed by self-interest, getting the best price – by the profit motive.
The free-market system has worked quite well for much of history; better than the ‘planned’ economies of communist nations anyway, for the most part. But something has changed in the last decade or two. The market for goods and money has become truly global in a way that it never was before, and in the process it has become less accountable and less regulated.
As the proportion of accumulated wealth has risen relative to produced wealth, so the ability of governments to influence national economies has declined, because accumulated wealth, when in the form of money or financial investments at least, can be moved around easily. It often ends up in countries, or even small island dependencies such as the Cayman Islands or Channel Islands, that deliberately attract wealth by promising not to tax it, and which encourage transnational corporations to register with them by offering favorable secrecy laws and minimal regulation.
The wealth of industry, on the other hand, has traditionally been more fixed; located in a real place in a real country, where there is still some governmental control over what goes on. Industrial wealth fed into the economy because it created jobs and made the majority a little wealthier, and, until recently, most of the profits of industry were reinvested in the economy, creating more jobs.
Figure 25
This has begun to change however, as large transnational corporations become wealthier and more dominant. Jobs can be created where labor is cheapest, companies registered where taxes are lowest. And rising productivity, as I mentioned earlier, means fewer jobs. More of the profits can be kept by company owners and executives. I examine this trend in more detail later in the book, but with regard to the value of money, the point is that governments have very little control over national currencies in the truly global free-market economy, even though it is governments that supposedly guarantee the value of money. Most monetary policy these days is limited to the setting of interest-rate targets and the issuance of money, and even these critical functions are to some extent beyond government control.
I will return to the matter of accumulated wealth later in the chapter, but first there is another important topic that needs to be addressed, and this is the system of money creation itself.
There has never been a perfect monetary system. Perhaps because of the subjective and relative nature of value, such a thing is impossible. But the system we have now is very far from perfect.
Fractional-reserve banking
It might not be a term that sets the pulse racing, but fractional-reserve banking lies at the heart of the monetary system of most countries these days. It refers to the fact that banks only need to hold cash reserves that represent a fraction of their customer deposits. It works on the basis that not all customers are going to withdraw all their cash at any one time, so there is no need to hold that amount in the bank. Banks can therefore lend out more money than they actually possess, which adds ready cash, or ‘liquidity’, into the economy.
The amount that must be held in the bank, known as the reserve ratio, is set by the central bank and is usually somewhere between 20% and zero. The reason it can be zero, which is theoretically the case in Britain for example, is that the central bank will always provide funds to commercial banks when they are short of cash. In practice, British banks hold around 3% of deposits and the rest is either lent out or invested in other ways. The US has a reserve requirement of 10% on some instant-demand accounts, but none on other longer-term deposits.
With a 10% reserve ratio, for every $100 a bank holds in deposits, it can lend out $90 and keep $10 in reserve. But that $90 loan might be invested somewhere else, enabling another bank to hold $9 and lend out $81. This process can theoretically go on until the initial $100 deposit has resulted in $900 of new money in the form of loans, although this is unlikely to happen to the full extent, as at some point the money will most likely be spent rather than reinvested.
This uncertainty as